The study of Corporate Finance seems to be a very generic part of business education. Still, it either falls in the trap of intimidating formulas or is superficially journalistic. Both extremes preclude the understanding of the core finance ideas, concepts, and models.
This Course is an attempt to avoid the above extremes. We discuss the core basis and mechanisms of modern corporate finance in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests and preferences of investors, reveal the true meaning of specific financial terms, and uncover important issues that are so often ignored in choosing and valuing investment projects.
The learners will gain insight into the essence of corporate finance. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses.

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From the lesson

Making the Choice of Good Investment Projects. NPV and Other Criteria. Why Is NPV Better?

We start Week 3 of the Course by the discussion of criteria of choosing investment projects. Beside NPV, the internal rate of return (IRR) and other approaches are introduced. We show why the NPV criterion is the best and why the application of others may lead to wrong investment decisions.

Then we focus on the main ideas to be taken into account while setting up cash flow patterns and making the choice of project on the basis of NPV. We mention some special issues – relevant costs, depreciation, inflation. We present the concept of equivalent annual cost (EAC) as a method of comparing projects of different length. Then we study the application of EAC in greater detail in a case.

Taught By

Konstantin Kontor

Transcript

Well, this week has been devoted to the proper way of using the NPV approach to label projects as good or bad and to make proper choices. In the first part, we've analyzed why the NPV criteria is the criterion is superior to other criteria. Which are, although sometimes easier to use, but still contain a fundamental traps that can in some cases result in wrong choices and potential damages. And then, we just said that in order to properly apply the NPV criterion, we have to do our homework in the extraction of these inputs. Specifically, for cash flows from the Council of the company. And then we also have to treat them properly, and that's what we have done in the second part of this week. And that ended up with the example that I gave in the previous episode. Because we also pointed out that it's important for us to be able to compare a projects with different length, and the major emphasis was made on the need to avoid most common mistakes. For example, we said that cash flows should always be taken on net After-tax Basis because unless or until you pay these taxes, you cannot use the residual cash flows to make comparisons, or to make proper basis for choices. Now, I'd like to add some of the things that must be taken into account. But these things are not minor but they are really a little bit trickier and oftentimes they are not so fundamental. We discuss some of them in some greater detail in our third course than we deal with major accounting. But for now, I'll just briefly wrap them up. So other issues about NPV. Well, first of all, this is optimal timing of investment. Here, there are at least two major ideas. One idea is that if you, for example, change your equipment or do something, and then, if you postpone that, then, you will have superior information. Because over this time, the expectations will properly become facts. But at the same time, you won't be able to get all the necessary information, and you will not be able to remove uncertainty this way. So here, this is one component. The other is that sometimes, as we saw in the previous example, when we compare the electrical and gas heating systems, we saw that you might have a preference to walk in the work of this is of a longer period of time. But it may not be the best thing if you use the NPV criterion. And there is another dimension to that, that we discuss later in this course, that deals with potential real options. So if time goes by, you might have incoming information that will result in your certain actions in the future. And the ability to take these actions may be very valuable. Now, the next thing is when you use EAC. Then sometimes, this EAC is used for replacement of equipment. That's about what I was saying just a few moments before. And if you did so, then it's again, seems easy to do this. But when you talk about replacing something, you have to be very careful about the quality of the financial approach, and the corresponding accounting approach because some of the actions associated with this replacement may interfere with the need to show some accounting efficiency, if you will. Again, all that is discussed in much greater detail on our third course, but that must just be kept into account for now. The next thing that is close linked to that is excess capacity. Remember, when we need capacity, when we talked about the bottling plan that can no longer meet the demand, that was a big problem. But by the same token, excess capacity is not free of charge. If you installed too powerful a computer for your office, then you could have saved on that. And you obviously plan to be able to use it more intensively in the future, but it also depends. So, most often people normally do not get the most powerful, and the thing with the greatest capacity because it might prove to be too expensive. Now, and the next set of things, this is the overall limitations. Here, we can quote limitation of capital, because for some projects that we might otherwise be willing to take, we just do not have enough money. That's not only that, there may be also key resource factor. Let me give you an example, let's say you are building. Again, this is studied in some more detail in our third course. The idea is very simple. Suppose that you make a very special product, and in this product, there is the core part without which, you cannot produce it. It can be shown that maybe it is your ability to build this very part. That is a key resource limitation. If you cannot build more of these pieces, then although you can make a lot more bodies or other pieces of this equipment, without that, you won't be able to assemble the final product. And in this case, this limitation may be really crucial, and without that you won't be able to proceed. So there are some other limitations between capital resources, and I would not go deeper than that for right now. But I would like to really wrap up with the thing that I've told you many times before, but now it's a time to repeat it once again. We have to properly deal with inputs. So, the idea is very simple. If we cannot extract proper inputs, a lot from what we've talked about for this week becomes irrelevant. Because you can use more advanced approaches, but if your raw materials, if your inputs are of poor quality, if they have huge ranges in these expectations, if they are not certain, or if they are not reliable, or if they are likely to change, given the minor change over the environment, but they would change significantly. All that will nullify all the pluses of the more advanced approaches, and more careful treatment of these inputs that we've developed throughout this week. So basically, as always people say, garbage in, garbage out. So you have to be really very careful in securing some quality of these inputs. You may not be able to come up with the best inputs in most cases. But you have to make sure that there is at least something that is reliable. Otherwise, even if you played sensitivity analysis, even if you try to apply other things, then the ranges of your results will be so great that will effectively prevent you from making realistic choices. So here, is the time to take another pause, and to take another big portion of assignments. Because all these things, as you've seen, they do deal with some formulas although they are quite straightforward. But it does require some hands-on experience, and there is no other way to learn that. And the next week, we will talk about discount rates. We will use a powerful mathematical approach to that, and we will be able to somehow identify them. Somehow to extract them from what is seen on the market. So that will be quite an advancement. For now, I wish you good luck with your assignments for the third week, and I'll see you next week.

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